Fire Marshal in a Nightclub: Richard Bookstaber Explains Financial Risk Management

Richard Bookstaber has authored two superbly written and thoughtfully argued books on the flaws of the financial system. His first, A Demon of Our Own Design (2007), was focused on the system’s complexity and foresaw the global financial crisis of 2007-2009. His latest book, The End of Theory, argues that economics as currently understood is poorly designed to understand the financial system and its potential for crises, and calls for agent-based modeling (ABM) as an alternative to the techniques used by most economists.

We spoke on July 20, 2017.

Bookstaber is chief risk officer of the University of California’s pension and endowment fund, one of the world’s largest. Previously, he was at Moore Capital, Bridgewater, and several other institutions, as well as the U.S. government’s Office of Financial Research. His Ph.D. in economics is from MIT.

What’s the matter with economics?

Siegel: You say that “economics works, until it doesn’t… Economics…not only leaves the cascades and propagation over the course of a crisis unexplained but also asserts that they are unexplainable.” In this context, what do you mean by economics? Microeconomic price theory? Macro? Financial economics? Are all of them flawed?

Bookstaber: Mostly I am talking about macroeconomics as it is currently taught in graduate schools, so that is what the economists at the Fed and at large financial institutions know best.

Siegel: What are the essentials of this macro theory?

Bookstaber: This theory or approach to the world is applied in central banks through what are called, in the trade, dynamic stochastic general equilibrium (DSGE) models. At least that is how it is applied by central bank economists. How much it is used by the policy makers is another question. I hope the answer is, “not much.”

The theory asserts that everyone in the economy is proxied by a single representative agent, a hypothetical individual who lives in a stable, equilibrium world, and makes fully informed, rational decisions.

Siegel: Why, in your view, is this theory, or set of theories, inadequate for understanding the economy, with its periodic disruptions, financial crises, and so forth?

Bookstaber: First, I’m not saying economics fails broadly. I’m focusing specifically on financial crises, and on the financial part of financial crises – what happens in financial institutions, not what happens when the crisis breaks through to affect the real economy.

What happens is that some shock spreads to affect critical components of the system, including those that had no apparent connection to the initial shock. Think, for example, of the propagation that started with the subprime mortgage market, really a backwater market, in 2008. This is analogous to minor traffic incident causing a huge traffic jam that affects people who are far from the incident, or, tragically, to the 2,400 Hajj pilgrims in Saudi Arabia who died a few years back in a stampede that occurred seemingly out of nowhere. Such stampedes have occurred in many times and places.

These are called emergent phenomena. From a distance, it looks like the cars on the highway, or the crowds in the street, have begun to behave like a single organism. This occurs because each agent’s behavior affects the environment in which every other agent operates. In neoclassical economics with a single representative agent, such behavioral contagion can’t occur, but in real life it does. If a model is going to be useful for understanding financial crises, it needs to take into account emergent phenomena.